Why economists can’t see a recession coming

Former governor of US Federal Reserve Alan Greenspan was once the poster boy of America, representing everything that was right with the economy.

Cut to the present, Greenspan is now the nation’s favourite punching bag.

So what led to this change in perception?

The foremost reason being Greenspan, like many others, couldn’t see what lay ahead. He assumed what was yesterday, would be there tomorrow. But things clearly didn’t turn out the way he had assumed or desired to be.

In fact, it even makes sense to assume that the status quo, where things are just about right, will prevail. Robert J Barbera, chief economist, Investment Technology Group, in his book The Cost of Capitalism — Understanding Market Mayhem and Stabilizing our Economic Future, writes: “Since the economy is not in a recession 80% of the time, the safe strategy is to predict recessions only when they have already arrived! That

means you’re right 80% of the time. Simply put, forecasting the recent past is the way to go and it is the dominant strategy employed by professional forecasters.”

Barbera argues in the book that even an economist as famous as Paul Samuelson, who in 1970 became the first American to win a Nobel Prize in economics, shared similar thoughts on predicting the future. “Indeed, no less a giant among economists than Paul Samuelson endorsed the methodology some years ago. When asked how far into the future a good economist could forecast, he replied, ‘One quarter back,’” Barbera writes.

So does that mean one shouldn’t make guesses in the first place given the unreliability of forecasts?

Barbera says forecasts ought to be made. “The simple truth is that in order to get on with everyday business, all of us must act as if we have sense of what lies ahead.”

But what is it that makes the business of forecasting so difficult?
The author says, “Most people’s opinion about the future is that it will extend the trends they witnessed in the recent past. People’s opinions about the future change, for the most part, only when they are confronted with changing economic circumstances.”

Barbera adds that a brilliant example of this “group think” can be seen in the business media, and particularly on business news channels like CNBC.

“On a real-time basis, information about emerging trends is processed, leading to the shaping of a baseline of opinion about ongoing economic performance. Spend sometime watching CNBC and the process reveals itself. The consensus outlook for the economy looks more of the same. There are always mavericks voicing contrary opinions. But the conventional view about what comes next almost never changes in the midst of the trend,” he writes.

And that explains to a large extent why, in the midst of a boom, most experts expect the upswing to continue. “The longer a trend stays in place, more the people’s conviction levels build. Coming out of a recession, a year’s worth of reasonable growth with low inflation, will likely move the conventional view towards expecting the same for the year to follow,” Barbera explains.

So the belief that tomorrow will be like yesterday leads to predictions and forecasts that all sound the same. But is the view altogether irrational

“Not really,” says Barbera. “Most of the time, tomorrow bears a close resemblance to yesterday. After all, both industry and economic trends tend to last for years, not for days. Once we acknowledge that we confront a world of pervasive uncertainty, it is quite reasonable to decide until circumstances change, we will plan as if present circumstances are likely to persist.”

The author argues that a majority of economic forecasters also rely on this rear-view method of forecasting. “And that explains the painful fact that the economic forecasting community, as a group, failed to predict the arrival of each and every recession over the past thirty years. When economists are confronted with deteriorating economic statistics, they acknowledge that a recession is the risk, but until the downturn grips the data, they project continued economic growth,” Barbera says.